Calculating interest rates The real risk-free rate (r*) is 2.80% and is expected
ID: 2808282 • Letter: C
Question
Calculating interest rates
The real risk-free rate (r*) is 2.80% and is expected to remain constant into the future. Inflation is expected to be 4.05% per year for each of the next four years and 2.85% thereafter.
The maturity risk premium (MRP) is determined from the formula: 0.10 x (t – 1)%, where t is the security’s maturity. The liquidity premium (LP) on all Gauge Imports Inc.’s bonds is 0.50%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):
1. Gauge Imports Inc. issues fourteen-year, AA-rated bonds. What is the yield on one of these bonds? (Hint: Disregard cross-product terms; that is, if averaging is required, use an arithmetic average.)
A. 8.59%
B. 8.09%
C. 7.29%
D. 5.40%
2. Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?
A. The yield on a AAA-rated bond will be higher than the yield on a BB-rated bond.
B. A AAA-rated bond has less default risk than a BB-rated bond.
Rating Default Risk Premium U.S. Treasury — AAA 0.60% AA 0.80% A 1.05% BBB 1.45%Explanation / Answer
1.
the yield on one of these bonds
=2.80%+((4.05%*4+2.85%*10)/14)+(0.10*(14-1)%)+0.50%+0.80%
=8.59%
2.
B. A AAA-rated bond has less default risk than a BB-rated bond.
because AAA rated bonds has better credit profile than BB rated bonds
the above is answer..
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